Side Letters: Just Paper Tigers, Or Do They Roar?

Side letters document bespoke arrangements between all or certain parties to a financing transaction and supplement the terms of the principal documents thereto. Becoming increasingly popular with stakeholders, and with the ability to benefit both borrowers and lenders, in this Alert we will examine some key considerations when making use of side letters and their interplay with the terms of a credit agreement.

Purpose

Generally speaking, traditional lenders (e.g. banks and large financial institutions) have tended to use side letters to reflect specific internal policy points, whereas private credit funds have – in addition to this purpose – also used them to override terms of a credit agreement to make them more lender friendly. Side letters allow sponsors to confidentially document lender-specific provisions without involving the wider lender group and, more generally, without the market becoming aware of any specific concession. Common side letter terms include rights of first offer/refusal (i.e. terms allowing existing lenders to have opportunities ahead of others to participate in future debt issuances), greater lender transferability rights, more flexibility around confidentiality provisions and the tightening of key restrictive covenants such as debt incurrence or leakage via restrictive payments or permitted investments.

Important considerations

Here are some of the key issues to consider when documenting terms in side letters:

Designation as a 'Finance Document': A side letter will not necessarily be designated as a 'Finance Document' for purposes of the credit agreement given its nature as a side arrangement between a subset of parties thereto. In fact, it is typically the case that a side letter is not a Finance Document; but what are the implications of this? In not being so designated, a breach of the side letter will not trigger an event of default under the credit agreement, so the protective mechanisms built into the credit agreement (namely, the ability to accelerate the loan and/or enforce security over secured assets) will not be available. Instead, in order to have a chilling effect on any party contemplating violating the terms of any such side letter, lenders are therefore relying on a combination of having (1) remedies for breach of contract (which will involve meeting various legal tests that are not guaranteed to be met) and (2) the moral suasion that breaching any form of written agreement between sophisticated investors will have – neither of which has as clear an outcome as relying on the event of default regime under the credit agreement. Furthermore, if the side letter seeks to document additional economics, these shall not constitute 'Secured Obligations'; meaning if there is any other event of default under the documents, such economics will not form part of the secured claim. However, a side letter not being a 'Finance Document' has its advantages – for example, if the lenders who benefit from a side letter do not constitute the 'Majority Lenders' (or whatever higher percentage of lenders is required to amend the relevant terms of the credit agreement), there is a risk that a side arrangement documented in a Finance Document could be amended or waived by other lenders which are not beneficiaries thereof. In addition, it may prove pointless in a letter being designated a Finance Document if the lender beneficiaries thereof do not constitute the Majority Lenders, as they will not be able to direct any enforcement of its terms.
Disclosure: It is a common misconception that designating a side letter as a Finance Document will automatically mean that the side letter will or can be disclosed to the Agent (and thus, that the Agent is permitted to and/or can be obligated to disclose the side letter to others): close attention needs to be paid to the relevant provisions of the credit agreement itself before parties are dissuaded from actually using side letters as part of transaction, as this is not necessarily the case. In any case, confidentiality provisions within a side letter itself should be reviewed carefully – for example, if a side letter permits additional lender transfers to those contained in the credit agreement but the Agent is not a party to the side letter and disclosure to the Agent is not expressly permitted, it will be difficult to actually enforce such terms, specifically at a time where borrower-lender relations may be fractious and a waiver of such confidentiality provisions by the borrower is not forthcoming. To ensure this would technically work, the side letter both needs to permit disclosure to the Agent and needs to constitute the consent from the Company required by the credit agreement in order to enable the Agent to affect the desired transfer regime.
'Entire agreement' clauses: The credit agreement to which a side letter relates will typically include an 'entire agreement' clause, which (as the name suggests) states that the credit agreement contains the entire agreement between the parties and shall supersede any other negotiations or agreements. Where a side letter relates to the same subject matter as the credit agreement, an entire agreement provision in the credit agreement could potentially cut across the side letter and raise questions as to its enforceability. In LMA-style credit agreements, it is common to see entire agreement clauses limited to specific elements of the agreement (e.g. confidential information). Nevertheless, parties should have regard to any potential conflict during the drafting process.
Maintaining status as a beneficiary: Parties should take caution when agreeing side letters which contain provisions requiring a lender to maintain a certain percentage of total commitments for the side letter to remain 'live'. A dilution of a lender's percentage can happen involuntarily – for example, where the credit agreement does not contain robust right of first offer/refusal language in favour of such a lender, a future debt issuance can result in the necessary percentage threshold being lost. Equally, lenders regularly carry out internal transfers of a credit position during its life, and the ability for any such transferees to benefit from side letter positions should ideally be drafted within the side letter at the outset to avoid this loss of position.
Side letters throughout the tenor of a deal: Side letters may be drafted either at the same time as the credit agreement or earlier at the term sheet stage; if the latter, drafting may be in the form of broad principles, and therefore special attention needs to be paid at long form stage to ensure such broad drafting accurately 'overrides' each of the provisions intended by the side letter parties. In addition, amendments to a credit agreement after the signing of a side letter need to be considered in order to ascertain the impact on bespoke side letter arrangements.
Creating binding obligations: A basic but critical point; a side letter needs to meet key elements to create a valid contract under English law, one of which being consideration (i.e. something must be provided in exchange for the 'promise' set out in the side letter). Where the issue of consideration is ambiguous, a side letter may be executed and delivered as a deed (as deeds do not require consideration to be enforceable).

Closing remarks

As discrete arrangements which exist alongside the terms of the credit agreement, side letters present flexibilities for both lenders and borrowers alike, but attention must be paid to the various pitfalls outlined above.

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_{This article is prepared for the general information of interested persons. It is not, and does not attempt to be, comprehensive in nature. Due to the general nature of its content, it should not be regarded as legal advice.}